MINICASE Chapter 9 Any help is appreciated thanks so much! Jack Tar, CFO of Shee

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MINICASE Chapter 9 Any help is appreciated thanks so much! Jack Tar, CFO of Sheetbend & Halyard, Inc., opened the company confidential envelope. It contained a draft of a competitive bid for a contract to supply duffel canvas to the U.S. Navy. The cover memo from Sheetbend's CEO asked Mr. Tar to review the bid before it was submitted. The bid and its supporting documents had been prepared by Sheetbend's sales staff. It called for Sheetbend to supply 100,000 yards of duffel canvas per year for 5 years. The proposed selling price was fixed at $30 per yard. Me. Tar was not usually involved in sales, but this bid was unusual in at least two respects. First, if accepted by the navy, it would commit Sheetbend to a fixed-price, long-term contract. Sec- ond, producing the duffel canvas would require an investment of $1.5 million to purchase machinery and to refurbish Sheetbend's plant in Pleasantboro, Maine. Mr. Tar set to work and by the end of the week had collected the following facts and assumptions: The plant in Pleasantboro had been built in the early 1900s and is now idle. The plant was fully depreciated on Sheetbend's books, except for the purchase cost of the land (in 1947) of $10,000. Now that the land was valuable shorefront property, Mr. Tar thought the land and the idle plant could be sold, immediately or in the near future, for $600,000. Refurbishing the plant would cost $500,000. This investment would be depreciated for tax purposes on the 10-year MACRS schedule. The new machinery would cost $1 million. This investment could be depreciated on the 5-year MACRS schedule. The refurbished plant and new machinery would last for many years. However, the remaining market for duffel canvas was small, and it was not clear that additional orders could be obtained once the navy contract was finished. The machinery was custom-built and could be used only for duffel canvas. Its secondhand value at the end of 5 years was probably zero. Table 9.4 shows the sales staff's forecasts of income from the navy contract. Mr. Tar reviewed this forecast and decided that its assumptions were reasonable, except that the forecast used book, not tax, depreciation. But the forecast income statement contained no mention of working capital. Mr. Tar thought that working capital would average about 10% of sales. Armed with this information, Mr. Tar constructed a spreadsheet to calculate the NPY of the duffel canvas project, assuming that Sheetbend's bid would be accepted by the navy. He had just finished debugging the spreadsheet when another confidential envelope arrived from Sheetbend's CEO. It con- tained a firm offer from a Maine real estate developer to pur- chase Sheetbend's Pleasantboro land and plant for $1.5 million in cash. Should Mr. Tar recommend submitting the bid to the navy at the proposed price of $30 per yard? The discount rate for this project is 12%. 288 TABLE 9.4 Forecast income statement for the U.S. Navy duffel canvas project (dollar figures in thousands, except price per yard) Part Two Value Year: 1 2 3 4 5 l 1 . Yards sold 100.00 100.00 100.00 100.00 100.00 2. Price per yard 30.00 30.00 30.00 30.00 30.00 3. Revenue (1 x 2) 3,000.00 3,000.00 3,000.00 3,000.00 3,000.00 4. Cost of goods sold 2,100.00 2,184.00 2,271.36 2,362.21 2,456.70 5. Operating cash flow (3 - 4) 900.00 816.00 728.64 637.79 543.30 6. Depreciation 250.00 250.00 250.00 250.00 250.00 7. Income (5 - 6) 650.00 566.00 478.64 387.79 293.30 8. Tax at 35% 227.50 198.10 167.52 135.72 102.65 9. Net income (7 - 8) $422.50 $367.90 $311.12 $252.07 $190.65 Notes: Yards sold and price per yard would be fixed by contract. Cost of goods includes fixed cost of $300,000 per year plus variable costs of $18 per yard. Costs are expected to increase at the inflation rate of 4% per year. Depreciation: A $1 million investment in machinery is depreciated straight-line over 5 years ($200,000 per year). The $500,000 cost of refurbishing the Pleasantboro plant is depreciated straight-line over 10 years ($50,000 per year).

Explanation / Answer

Option 1 - Production of duffel canvas for Navy Total Cash Flows 0 1 2 3 4 5 Initial Investment -1500000 Refurbishing plant -500000 Increase in working capital -300000 Cash Flows 655000 656400 574416 495204 417685 Sale of Land at the end of the project 600000 Total Cash Flows -2300000 655000 656400 574416 495203.5 1017685 Discount Rate 12% Disount Factor (1/(1.12)^year 1 0.892857 0.797194 0.71178 0.635518 0.567427 Discounted Cash Flow -2300000 584821.4 523278.1 408858 314710.8 577461.8 Net Present Value 109130 Option - 2 Sale of land and plant at Pleasantboro to Real Estate Developer Amount of Cash Received 1500000 As Option 2 provides the cash upfront which is more than the Net Present Value the same should be accepted Calculation of Cash flows 1 2 3 4 5 Sales 3000000 3000000 3000000 3000000 3000000 Cost of Goods Sold 2100000 2184000 2271360 2362210 2456700 Operating Cash Flow 900000 816000 728640 637790 543300 Depreciation (MACRS) 200000 360000 288000 230400 184400 Income 700000 456000 440640 407390 358900 Tax (35%) 245000 159600 154224 142586.5 125615 Net Income 455000 296400 286416 264803.5 233285 Cash Flow (Net Income + Depreciation) 655000 656400 574416 495203.5 417685 Increase in working Capital (10% of sales) 300000 Proposed supply amount 100000 yards Sales Price 30 per yard Depreciation rate (10 years MACRS) 0.1 0.18 0.144 0.1152 0.0922 0.0737 Working Capital 10% of sales Investment in Machinery 1500000 Cost of refurbishing plant 500000 Total investment 2000000 Fixed Cost 300000 312000 324480 337459 350958 Variable Cost 18.00 18.72 19.47 20.25 21.06 growth rate of costs 4% Variable costs 1800000 1872000 1946880 2024755 2105745 Cost of Goods Sold (VC+FC) 2100000 2184000 2271360 2362214 2456703

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